Alternative indices are experiencing rapid growth, fuelled by high equity market volatility and the realisation that traditional market capitalisation-based indices have exposed investors to concentrated risk.

The first alternatives to market-cap indices were created in the US 30 years ago. But it has really only been since 2005 that alternative indices – which invest in securities and bonds based on particular metrics such as dividend yield, cashflow or sales; or that meet certain strategies such as lowering volatility or reducing risk – have moved into the limelight as investors seek to diversify their portfolios and improve performance.

Forming an accurate picture of the appetite for alternative index strategies is difficult as many investments are made on a bespoke basis by institutional investors, but managers and index providers say the growth from a low base has been rapid.

Asset growth

Publicly available information on exchange-traded funds, which track an underlying index or basket of stocks, gives some indication of the growth of structured indices. Fund manager BlackRock’s alternative-index assets, which include ETFs, have grown from less than $100m in 2008 to about $12bn in June 2012.

Alternative-index ETFs are still dwarfed by market cap-weighted ETFs in terms of assets. But Xiaowei Kang, director of index research and design at S&P Dow Jones Indices, said: “The SPDR S&P 500 ETF has assets of around $120bn, while the Low Volatility ETF version has around $2.5bn and the Equal Weight ETF version has around $3bn. The assets might be small in comparison to market cap-weighted indices but they have grown rapidly.”

In theory, there are many different ways to draw up an index other than weighting the constituents by market capitalisation. In reality, however, there are three main alternative index strategies that have attracted the most assets.

Kang said: “The first category is diversification strategies, which includes, for instance, equal-weighting or risk-parity strategies. The second focuses on reducing portfolio volatility and includes minimum variance. The third looks at fundamental factors and weights the index by company metrics, such as intrinsic value, sales or cashflow measures.”

All of the main index providers – S&P, MSCI and FTSE – provide alternative indices for institutional investors. According to Kang, S&P and MSCI are the big players in this market, while the FTSE has a smaller business model. The structuring desks of many investment banks also provide bespoke products for institutional investors, while large ETF providers, such as BlackRock’s iShares business, run ETFs based on alternative indices as do some niche providers such as WisdomTree.

The popularity of alternative indices has been driven by various factors. During the tech boom and bust, the concentration risk of market-cap indices was brought into sharp relief. The financial crisis spurred growth further. Investors were spooked by the volatility of the equity market and looked for alternatives.
But one of the biggest appeals of alternative indices is that they are more sophisticated than a simple index tracker, yet they are transparent, highly liquid and have much lower management fees than actively managed funds.

Amit Bansal, senior structurer at Rabobank, said: “Now it’s so easy to create a bespoke index that investors can use it as a cheap synthetic way of taking a view on the market. A client might come to us and say they want a low-risk product that invests only in specific Asian companies and only in certain sectors. We can easily fulfil this request.

“Even though it might be a highly complex product, it looks like a simple vanilla product to the investor which can be very easily traded. It is a simple way to implement a sophisticated strategy.”

Alternative indices are considered a hybrid between a passive and an active strategy. The active component – what methodology to apply to achieve a particular outcome whether it is to reweight the index, reduce volatility or focus on other value metrics – has led to expectations that active managers could get involved in creating their own indices or track existing indices via ETFs.

Indeed, there are signs that some are preparing to launch in the alternative indices market.

US pulls ahead

Alan Miller, chief investment officer at wealth manager SCM Private, said: “Movement is more likely in the US than in Europe. A recent Bloomberg report said that Fidelity was considering offering actively managed ETFs. There appears to be more willingness to fulfil the demands of the modern investor in the US than there is in the UK, where the fund management industry has its head completely in the sand.”
Fidelity declined to comment on whether it would be offering actively managed ETFs as part of its new division to provide more specialised investment options.

However, some market participants believe that the barriers to entry are high. Such a move would require considerable long-term investment in both front and back-office technology and talent in order to compete. Counterparty reliability and reassurance about the index’s longevity are also issues for investors, according to FTSE.

Overall, however, Peter Gunthorp, managing director of research & analytics at FTSE, believes that the low fees of index tracking will be the biggest barrier to entry for active managers. He said: “Even though alternative indices have an active component, they are charging much lower fees than an active manager would charge. And it’s doubtful that active managers want to dilute their revenue streams.”